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The Fed has already taken some unconventional monetary measures to stimulate the economy, but they haven’t been entirely effective. Professor Sumner says the central bank needs to take a different approach: it should make a credible commitment to spurring and maintaining a higher level of inflation, promising to use newly created money to buy many kinds of financial assets if necessary. And it should even pay negative interest on bank reserves, as the Swedish central bank has started to do. In essence, negative interest rates are a penalty placed on banks that sit on their money instead of lending it.

Much to the chagrin of Professor Sumner, the Fed has been practicing the opposite policy recently, by paying positive interest on bank reserves — essentially, inducing banks to hoard money.

Of all the things the Fed has done to fight the recent financial meltdown, this is the one I’ve never quite understood: paying interest on bank reserves. As a general policy it might be a good idea (Steve Randy Waldman wrote a decent primer about it here), but as Sumner points out, in the middle of a financial crisis it gives banks an incentive to hoard money at the Fed instead of loaning it out. That’s the opposite of what we want.

On the other hand, minimum bank reserves are still mandatory in the U.S., so I guess I also don’t understand the point of negative interest. Banks are required to keep those reserves at the Fed, so they couldn’t withdraw them even if they wanted to. Essentially, a negative interest rate would just be a tax on banks.

So, as usual, I’m confused. This doesn’t really seem to make sense either way.

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